Less Than Forthright

FX markets continue in the doldrums with limited price action overnight. Despite concerns that risk is generally coming under pressure (just look at equity prices yesterday and today), movement in this market remains lackluster at best. In fact, within the G10 space, the biggest mover overnight was the pound, which has rallied just 0.3% on the strength of a surprisingly good IP report (+0.7%, exp +0.3%). Otherwise, the rest of the activity can be measured in scant pips of movement.

It is this lack of activity that has led market participants to focus on the announced changes in Chinese policy regarding foreign investment in financial firms. Historically, there have been strict limits on the percentage of control any foreign person or entity could have over a Chinese bank or securities firm. Certainly, there was no ability to be a majority owner, and in practice, ownership had been constrained below 25%. In fact, in the wake of the financial crisis, the largest investment stakes by American banks had been liquidated as Citi, BAML and Goldman all sought to reclaim capital to address their own domestic issues. Of course, since then, Chinese banks have expanded significantly and now find themselves hugely leveraged and heavily reliant on Wealth Management Products for financing which leaves them subject to significant funding risk. Non-performing loans also continue to climb, and the government continues to direct the largest banks to lend where the government deems appropriate.

With that as a background, President Xi addressed the Asia-Pacific Forum regarding his vision of the future, which included multi-lateral agreements and much investment into China. Subsequently, the government announced a loosening of restrictions on investment in financial companies, claiming they will allow majority ownership by foreign entities within three years. Alas, it is easy to look at China’s history of foreign investment strictures and remain skeptical of the potential benefits available to any foreigner. Remember, just a year ago, when the renminbi was under pressure and capital was flowing out of China like a river, they were quick to establish capital controls and prohibit ‘non-strategic’ foreign investment by Chinese companies. And this despite their recent inclusion into the SDR where they claimed a freely convertible currency!

My point is, the Chinese do nothing that is not directly beneficial to their own country, which is completely fine, but which also means they want something specific from this action. My gut tells me that they are simply looking for foreign capital to help clean up the mess that is the Chinese banking system, and once they have it, there will be no compunction in changing the rules again. How, you may ask, will this impact the CNY? In the short run, I expect that it will have limited impact, although as we go forward, I would look for the renminbi to continue its gradual strengthening. Ultimately, I continue to believe that the PBOC will need to allow the currency to weaken as a relief valve for the strictures on the economy, but that is a politically fraught decision there, and so the timing of any future weakness remains extremely cloudy. Quite frankly, were I in a payables position in China, I would be actively hedging here, taking advantage of the positive forwards and what I believe will be ongoing mild appreciation of the yuan. And for those of you who pay USD to your Chinese suppliers, consider asking to pay in CNY, it may be far more advantageous over time.

Away from the China story, the only EMG currency to move significantly overnight was ZAR, which has fallen 1.0% after comments by the central bank Governor, Lesetja Kganyago, that despite rising inflation, the central bank would be able to continue to support the economy. In other words, don’t look for policy to tighten very much to fight that rising inflation. It should be no surprise that the rand has fallen on those comments. But away from that, EMG remains dull as well.

This morning’s only data is Michigan Sentiment (exp 100.9), which has been in a steady climb since bottoming back in the middle of 2011 at 55.8. There are no Fed speakers on the calendar until Monday, and so once again, the FX market will be looking elsewhere for its direction. If we continue to see equity prices under pressure, that could well lead to a fuller risk-off session, but the past several years have shown that the ‘buy the dip’ mentality remains extremely robust, and so despite futures pointing lower this morning, I expect those losses to be reversed before the session ends. If they are not, however, beware. Anything that occurs opposite to the narrative is going to have significant repercussions. Risk appetite has been artificially inflated by the Fed’s QE program since its inception, which means that equity positions are far larger, and more leveraged, than they would otherwise be in a more ‘normal’ monetary environment. These things can unwind quite rapidly, as evidenced in 2008-9, so caution is needed. Once again I will say that if there is mild risk aversion, the dollar will likely suffer, but if things begin to really unravel, my money is on the dollar to regain its position as safest haven of all. This is not today’s story, but one, I fear, for the not too distant future.